RachelKoning Beals

News editor

Subprime auto-loan default rates match those seen just before the 2007-2009 recession. It’s a red flag that’s been flapping for some time for analysts worried it could pose risks to the broader credit market, bank health and, ultimately, the consumer-driven economy.

Those concerns have been offset, in part, by other considerations: strength in loans to higher-credit individuals and a growing economy’s potential to buffer a strained lending market for the lowest-rated, or subprime, borrowers.

Plus, some temporary factors are at work, such as a delay in personal tax refunds that could crimp consumers’ ability to make their car payments on time, but only for a short time.

UBS analysts Matthew Mish and Stephan Caprio, in a Thursday note, don’t see subprime auto loans as an immediate threat to financial stability, but they see plenty of reasons for concern. Namely, the pay gap between low- and moderate-income workers and their higher-income counterparts is only widening while the credit available to those bringing home thinner paychecks remains abundant.

Concerns were elevated in part by the latest reading for the National Automobile Dealers Association used-vehicle price index, down 8% year over year through February. Financed used-car ownership is more common among lower-credit-rated drivers. Borrowers are also taking out longer loans, in fact the longest on record, Experian reported.

Analysts, including the authors of the UBS note, have stressed the impact on the auto-lending market from an increased proportion of “deep-subprime” borrowers, as well as comparatively lax underwriting practices across nonbank lenders that include auto finance companies, captive finance firms (a company subsidiary meant to provide financing to customers buying the parent company’s product) and credit unions and thrifts.

Credit-rating firms and market participants have been scrambling to explain subprime default rates for recent vintages (loans made in 2015, 2016) that have now reached levels consistent with those originated just before the 2007-09 recession (see graphic below).

Looking familiar?

Mish and Caprio don’t take the nonbank involvement lightly, especially within the context of the overall health of the car-loan market. They note that a net 23% of U.S. banks forecast that U.S. consumer loan delinquencies (of which a significant share is auto related) would increase in 2017, according to the latest Fed Senior Loan Officer Survey.

“This would be the highest share of banks since 2007. Given that banks have focused their lending activities on prime borrowers [those with stronger credit scores], any worsening in higher-quality customers bodes poorly for subprime loans originated by non-banks,” Mish and Caprio wrote.

Banks are responding accordingly to worsening credit conditions that include falling car prices and dwindling loan-to-value (how much is still owed on the car compared with its resale value), Fitch Ratings has noted. But banks’ caution is only costing them more lost customers to captive auto finance companies and credit unions.

Notably, subprime auto loans are a much smaller slice of overall subprime lending than mortgages (one of the leading culprits in the financial crisis). Auto loans make up $179 billion of the over $1.2 trillion subprime debt total. It’s also easier to unload cars than houses. These factors have so far limited the fear of economic contagion.

“We do not believe this implies a pending downturn…but it is yet another data-point that investors should not overlook,” the UBS analysts said in their note. “One can add consumer delinquency trends to the sharp slowdown in bank and nonbank corporate borrowing as evidence that a growth rebound may be weaker than expected.”

Analysts from firms such as Wells Fargo & Co.
WFC, -0.50%
, the biggest underwriter of subprime auto bonds, to credit-rating agencies, including S&P Global Ratings, have noted the increasing riskiness of loans that get securitized.

Weakening conditions are showing up in the specialized bond market that takes on these bundled and repackaged loans.

Sixty-day delinquencies for bonds backed by deep subprime loans have risen 3 percentage points since 2012, compared with just 0.89 percentage points on all other subprime auto securities, Morgan Stanley’s Vishwanath Tirupattur, James Egan and Jeen Ng said in a research report dated March 24.

The biggest risk, of course, lies in what’s not known, especially if the economy faces an unexpected test in the short term.

“If subprime auto loan defaults are already nearing prior crisis levels, there are important questions to entertain ahead,” UBS’s Mish and Caprio emphasized. “What will they look like in a recessionary environment? What will recovery rates on defaulted auto loans be, considering they are already abnormally low? And finally, if non-banks have intermediated most of the lower quality consumer loans this cycle, will their business models, their sources of funding, and by extension their credit intermediation activities, prove resilient through a proper credit cycle?”

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